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Assessing Standard-of-Living Risk of Active Accumulators

The Active Accumulator is the most aggressive behavioral investor type.

Michael M. Pompian, 11/19/2009

In last month's article we reviewed the basics of assessing standard of living risk for Independent Individualists. To review, advisors often will recommend an investment program to clients based purely on the the results from a risk-tolerance questionnaire. One element that is rarely captured in a risk-tolerance questionnaire (or anywhere else for that matter) is the idea of how risky a person's lifestyle is in relation to their investment portfolio. To advise clients properly, financial advisors should assess the financial responsibilities of their clients and determine if clients have ample assets to cover these responsibilities and an appropriate asset allocation to match. The next behavioral investor type we will examine is the Active Accumulator. Our process is to review the basics of each BIT, discuss the effects of SLR on that BIT and then review an example of how we might modify the details of an investment program for each BIT, with and without an SLR.

Active Accumulators
The Active Accumulator is the most aggressive behavioral investor type. These clients are entrepreneurial and often the first generation to create wealth, and they are even more strong-willed and confident than Independent Individualists. At high wealth levels, AAs often have controlled the outcomes of non-investment activities and believe they can do the same with investing. This behavior can lead to overconfidence in investing activities. Left unadvised, AAs often trade or modify the composition of their portfolio too much, which can be a drag on investment performance. Active Accumulators are quick decision-makers but may chase higher risk investments. If successful, they enjoy the thrill of making a good investment. Some AAs can be difficult to advise because they don't believe in basic investment principles such as diversification and asset allocation. They are often "hands-on" investors, wanting to be heavily involved in the investment decision-making process. Biases of Active Accumulators are overconfidence, self-control, optimism, and illusion of control.

Scenario
Suppose you are beginning an engagement with an AA client, Mats. You give him a standard of living risk questionnaire after having tested for behavioral biases of growth-oriented clients and a standard risk tolerance quiz. Based on the answers to the SLR he has been identified as someone with a standard of living risk. This means that he may not have an extra cushion of money available to him to withstand a "shock to the system" such as a job loss, disability or other adversity based on his current lifestyle. Generally, this can mean that he should accept less risk in his portfolio than those clients without a standard of living risk. Since he is an Active Accumulator, he is unlikely to believe in basic investment principles such as diversification and asset allocation. This makes working with AA clients with an SLR more challenging than with some other BITs.

The following analysis presents two investment programs, one for Mats (with an SLR) and one for his brother Hans (without an SLR). Hans' investment program is based primarily on answers to a risk tolerance questionnaire and his behavioral biases but not on SLR since he does not have one. You are using Hans' portfolio allocation as a baseline for creating Mats'. Your basic task as to assess a retirement goal for your client and the associated return needed to reach that goal. When working with actual clients, you will need to adjust this analysis to suit your purposes.

Active Accumulator BIT With and Without an SLR
As we know, AA clients:
* Have primarily emotional biases
* Like to control the investment process
* May take more risk than is necessary to meet their financial goals
* May not believe in basic investment principles such as diversification and asset allocation

For Mats, an AA with an SLR, we are going to make an assumption that he may have difficulty sticking to a portfolio with a probability of a loss year at greater than 40%. For Hans, an AA client without an SLR, 40% may be okay, but sometimes AA's take on more risk that is necessary so being somewhat less aggressive may be the best course of action. The following table summarizes the investment programs for both Mats and Hans.

 Active Accumulator BIT With an SLR (MATS)

 Active Accumulator BIT Without an SLR (HANS)

Ø    Based on conversations with Mats, you determine that he needs an 8% return to reach his long-term goals. His risk tolerance indicated this portfolio:

Ø       Based on Hans's risk tolerance questionnaire, the following portfolio was generated with its associated risk and return statistics.

Asset Class

Cash

US Bonds

US LC Stocks

US SC Stocks

Real Estate

%

5

10

40

35

10

Portfolio Statistics

Projected Return

9%

 

Probability

of a Loss Year

45%

Std. Deviation

15%

 

 

 

Asset Class

Cash

US Bonds

US LC Stocks

US SC Stocks

Real Estate

%

5

10

40

35

10

Portfolio Statistics

Projected Return

9%

 

Probability
of a Loss Year

45%

Std. Deviation

15%

 

 

 

 

Ø    You recommend the following allocation, which is an RAA that delivers an 8% return and has
a 27% chance of a loss year and a lower standard deviation.

Ø      Based on conversations with the client, you determine that Hans needs an 8.5% return to meet his financial goals.

Ø      Thus, you recommend the following allocation.

 

Asset Class

Cash

US Bonds

US LC Stocks

US SC Stocks

Real Estate

%

5

15

35

35

10

Portfolio Statistics

Projected Return

8%

 

Probability

of a Loss Year

35%

Std. Deviation

14%

 

 

 

Asset Class

Cash

US Bonds

US LC Stocks

US SC Stocks

Real Estate

%

12

22

28

28

10

Portfolio Statistics

Projected Return

8.5%

 

Probability
of a Loss Year

40%

Std. Deviation

14.5

 

 

 

Advisors to Active Accumulators need to remember that AAs can be difficult clients to advise because of their aggressive mindset, and often resist advice when others try to impose rules-based investing as is customary with a diversified asset allocation program. Many Active Accumulators like to control their investment decisions which can cause them to constantly want to adjust their portfolios. As with Passive Preservers, who are also emotionally charged investors, advisors should avoid quantitative-oriented advice and focus on discussing how the money will be used and what goals it can achieve for the client. A good approach is to set aside time during client meetings to discuss these matters. This way, the advisor educates regularly and can incorporate concepts that he or she feels are appropriate for the client.

Next month we will discuss how to create a "best practical allocation" for a client.

Michael M. Pompian, CFA, CFP, is an investment consultant to ultra-affluent clients and family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients.

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